*remainder of Roach testimony*
A fragile global recovery
As day follows night, recovery will, of course, come. It always does. But the real issue is the character, or quality, of the coming global upturn. Hope springs eternal on that score. Financial markets are lined up on the optimistic side of the 2002 outcome -- yield curves have steepened, equity cyclicals have rallied, and next year’s earnings expectations are brimming with optimism. The risk, in my view, is that the outcome for the US and the broader world economy will not conform to these optimistic expectations -- that the world will remain on a decidedly subpar growth trajectory.
Such are the realities of what has been dubbed a U-shaped world. By definition, a U-shaped upturn is a protracted period of subpar growth. Morgan Stanley’s current baseline prognosis calls for 3% average growth in world GDP in 2001-02 -- an outcome fitting that description to a tee. It depicts a world economy that falls short of its long-term growth trend by about 0.7 percentage point per annum over this two-year interval. Moreover, I fear that risks could tip to the downside of the scenario, suggesting that the world’s potentially chronic growth deficiency will become even more pronounced. In such a subpar growth climate, the risk of a recessionary relapse is high. The world economy will be lacking in both the leadership and the cyclical resilience that typically cushion unexpected blows. Little wonder the world has tipped so quickly back into recession in the aftermath of the crisis of 1998.
But there is a deeper and more profound meaning to this U-shaped world. On the one had, it reflects a worrisome imbalance in the broader global economy -- the world has simply become too dependent on the United States. Lacking in structural reforms, the world has been unable to unlock the efficiencies that would create new and autonomous sources of domestic demand. Instead, on the heels of a US-led boom in global trade, the rest of the world took the easy way out -- hitching itself to surging external demand. Only through structural reform can the global economy wean itself from excessive dependence on the American consumer and the US IT cycle.
A U-shaped world also poses a major challenge to the United States: America must now begin the heavy lifting that is needed to come to grips with the painful legacy of a popped financial bubble. Rationalizing the great IT capacity overhang is at the top of that agenda, followed by a long overdue need to rebuild personal saving. The bubble took America to excess, and those excesses must now be purged. As I put the pieces of global economic recovery together, I worry most about the quality of the coming upturn. The quality factor hinges critically on the combination of reforms and structural change. Unfortunately, based on recent experience, there is little ground for encouragement.
This global recession is different. It is both the first recession of the Information Age as well as the first recession in the modern era of globalization. As such, it should be viewed as critical wake-up call. One can only hope it will trigger structural reforms that will rejuvenate domestic demand in the broader global economy. With any luck, it should also force America to come to grips with many of its own post-bubble excesses. If progress is made on those counts, a high-quality upturn in the global economy will ensue. If, however, the world sidesteps the challenge and squanders the opportunity for meaningful reform, a low-quality rebound will occur. That, unfortunately, would be a setup for an even more painful day of reckoning. The stakes are enormous for a world now back in recession.
America’s external imbalance
The United States has shouldered a heavy burden as the engine of global growth. Excesses have built in the structure of the domestic economy. That’s the message from the Nasdaq bubble, a negative personal saving rate, and an outsize capacity overhang. At the same time, America’s economic and financial relationship with the rest of the world has been stretched as never before. That’s the message from a massive balance-of-payments deficit. All this poses risks on the dark side of the great American boom. While there can be no mistaking the extraordinary performance of the US economy in recent years, unfortunately, it has been built on a shaky foundation of increased foreign indebtedness. History demonstrates that such external imbalances cannot persist indefinitely. Something usually gives in response -- the currency, other asset prices, or the economy. Steeped in denial, few worry of such consequences. Therein lies a key risk for the global economy and world financial markets.
America’s current-account deficit hit 4.4% of GDP in 2000, and, by our estimates, is likely to hold near that share through 2002. That qualifies as the widest external gap of the post-World War II era -- a full percentage point larger than the previous record of 3.4% in 1986-87. We should avoid the slippery slope of looking to our trading partners as scapegoats. Our balance-of-payments deficit should not be viewed as an indication of a competitive assault on American markets. It’s not a Japan problem, or a China problem, any more than it’s a NAFTA problem involving Canada and Mexico.
If there is a scapegoat, it can be found in the mirror. America’s external imbalance is, instead, more a reflection of serious flaws in the macro structure of the US economy -- namely, a chronic domestic saving deficiency. From an accounting point of view, national investment must always equal saving. Consequently, when there is a lack of saving, one of two things has to happen: Either investment must be reduced or an alternative source of saving must be uncovered. America has opted for the latter of these options. A shortfall in domestically generated saving has been augmented by an inflow of saving from abroad -- inflows that can only be attained by running a massive external deficit.
The imbalance between domestic saving and national investment has not come out of thin air. It is very much a hallmark of America’s bubble economy. Five years of excess returns in the US stock market -- with the broad Wilshire 5000 surging by an average 25% per annum over the 1995-99 interval -- led to serious distortions of both consumer and business sector behavior. Consumers became convinced that an ever-rising stock market had become a permanent new source of saving. As a result, they drew down their income-based saving -- with the conventionally measured personal saving rate (national income accounts basis) falling from a pre-bubble 6.6% in late 1994 to a negative 1.2% in early 2001. Why should American workers save out of their paychecks if the stock market was automatically performing this function? Similarly, Corporate America became convinced that IT investment was a surefire recipe for enhanced returns in the stock market. The IT-led investment cycle soared in response, with business capital spending hitting a record 13.9% of nominal GDP in late 2000.
This juxtaposition between negative personal saving and record investment spending was a classic recipe for an ever-deepening current account deficit. Ironically, it occurred at precisely the moment when the federal government was getting its fiscal house in order -- moving from being a dis-saver to a saver by transforming seemingly open-ended budgetary deficits into surpluses. Indeed, government net saving (federal, state, and local, combined) moved from a pre-bubble deficit of 2.8% of nominal GDP in the fourth quarter of 1994 to a post-bubble surplus of 3.1% of GDP in early 2001. Unfortunately, this 5.9 percentage point positive swing in greater public sector saving was more than offset by the 7.8 percentage point decline in the personal saving rate. As a result, the net national saving rate -- a broad aggregate that includes personal, business, and public saving -- stood at only 4.8% in the first quarter of 2001; that’s little changed from the pre-bubble reading of late 1994 and less than half the 10% average of the 1960s and 1970s. Such a saving-short US economy had little choice other than to turn to foreign investors to finance its investment boom.
In retrospect, it is not surprising that an asset bubble produced this unstable state of affairs. Just as American consumers and businesses came to believe that ever-ebullient equity markets had become a new source of saving and excess return, so did foreign investors. They became more than willing to invest in dollar-denominated assets. Portfolio inflows surged from abroad, as did foreign direct investment, especially through a surge of European-led cross-border merger and acquisition activity. Largely as a result, foreign investors currently own 37% of US Treasuries, 46% of corporate bonds, and 11% of equities. It was the ultimate in virtuous circles. America’s New Economy prowess won over converts at home and abroad. The rest of the world was dying to buy a piece of the action, and so there was little reason for foreign investors to exact a premium on dollar-denominated assets. That’s exactly what should happen in a financial bubble -- that is, until it pops.
A venting of excesses
Yet, this is not a sustainable course for any nation. It depicts a US economy that is now living well beyond its means, as those means are defined by the domestic capacity to fund its investment needs. That, in my opinion is the painful legacy of a financial asset bubble that took our real economy to excess. Consumers have over-spent. Businesses have over-invested. And the United States funded these excesses by borrowing from abroad. There’s no telling when the music will stop. The longer this state of affairs persists, the greater will be the temptation to ignore its consequences. But the math is straight-forward: If left unchecked, an ever-widening current-account deficit raises the debt-servicing burden of international indebtedness to onerous levels. An increasingly larger share of domestically generated income will have to be exported to offshore creditors, who, in turn, establish an ever-larger claim on the ownership of dollar-denominated assets. An ever-widening current-account deficit implies that foreign investors will ultimately end up "owning" America -- unless, of course, something gives. And it usually does.
What should give, in my view, will be the high-flying US dollar. In the interest of full disclosure, I have been wrong on the dollar for close to a year. I felt the dollar would finally fall as the US veered toward recession. I also felt the current-account deficit would exacerbate the correction, once it got going. Over the past several years, however, the dollar call has not been driven by the current account -- instead it’s been all about capital flows. The rest of the world wanted a claim on America’s New Economy prowess and has been willing to pay up to get it. And despite the ever-widening current-account deficit, the dollar has soared. A broad index of the real trade-weighted value of the dollar is up 31% since late 1994 to a level that now stands just 12% short of its all-time high in March 1985.
Like any currency, the dollar, of course, is a relative price. If you’re negative on the dollar, you have to give careful consideration to the alternatives. This has not exactly been a year to fall in love with yen- or euro-denominated assets. But I suspect their day is coming. First of all, I continue to believe that the US economy will surprise on the downside. While the case for outright recession is admittedly arguable -- although one that I continue to embrace -- I remain convinced that any recovery is likely to be muted. That would most assuredly dampen the likelihood of an earnings resurgence that would validate the New Economy play still priced into the strong dollar.
At the same time, I believe that global investors could well begin to flirt with reform stories in both Japan and Europe. Indeed, the micro evidence of corporate reform is building in Japan. At the same time, structural change in Europe looks increasingly impressive -- underscored by tax and cost harmonization, improved labor-market flexibility, enhanced shareholder value cultures brought about through cross-border merger and acquisition activity, and ongoing deregulation. Politics remain the major impediments in both cases, in my view. If Prime Minister Koizumi, the reformer, carries the day in the upcoming Japanese Upper House elections, Japan’s political risk premium could start to narrow. And if European politicians start pulling together -- seemingly a stretch right now -- the euro might rise as well. The dollar could then finally be in trouble, with its downside exacerbated by an outsized US current-account deficit.
History shows that massive current-account deficits eventually trigger currency depreciation. The key word in this statement, of course, is "eventually." Economics often does a good job of revealing the endgame. Timing is a different matter altogether. But the lessons of the second half of the 1980s should not be forgotten: A then-record current-account deficit set the stage for sharp depreciation of the US dollar. I see no reason to believe that the endgame will be any different this time around.
But not only could the dollar give -- so, too, could America’s current-account deficit. Usually, it takes a recession to force a major current-account adjustment. That’s what is required to reduce domestic demand -- and the import content of such spending. That was the case in the early 1990s when the US last dipped into a mild recession. The current account went from a deficit of 3.4% of GDP in 1987 to virtual balance in 1991 -- an outcome assisted by the inflow of foreign payments that helped finance America’s military efforts in the Gulf War. If I’m right and the US economy slips into a mild recession, an import-led current-account adjustment could well be in the cards over the next year, as well.
Courtesy of the bubble-induced excesses of the 1990s, America is still living well beyond its means. Foreign investors have been more than willing to subsidize a profligate US economy. The combination of an overvalued dollar and a massive current-account deficit underscores the tensions that have arisen from this state of affairs. These distortions are not sustainable for any economy. As the US economy now begins to vent its post-bubble tensions, dollar and current-account adjustments seem more likely than not. And, by the way, that’s the last thing most investors currently expect.
Backlash against globalization?
Where might his all take us? The most worrisome possibility is that trade liberalization might give way to some form of protectionism. To the extent that slow growth prompts mounting layoffs, the political winds could well shift. The outcome might lead to the erection of new competitive barriers that would supposedly shield workers from the harsh winds of globalization. While the body politic has steadfastly resisted this temptation, there may be a change of heart as the world now slips into recession.
Public opinion polls reveal that US workers oppose several aspects of globalization -- especially trade liberalization, immigration, and foreign direct investment. (see Kenneth F. Schreve and Matthew J. Slaughter, Globalization and the Perceptions of American Workers, published by the Institute for International Economics, February 2001). Even during goods times, according to these polls, the benefits of globalization are thought to be largely outweighed by the costs. In tougher economic times, that resistance can only intensify.
Moreover, there is a gathering sense of anti-American sentiment around the world. In my travels, I have heard first-hand more than one distinguished European leader sarcastically describe globalization as "economic integration according to American rules." The Asian crisis took this resentment to a new level. Crisis-torn countries in the region deeply resent IMF-led bailouts that sent their economies into depression-like contractions from which many have never really recovered. With the US the IMF’s largest shareholder and the major architect behind the stringent bailout packages of 1997-98, America is blamed for much of which still ails Asia. The recent escalation of sino-US tensions underscores a different strain of this same animosity.
In my visits to Japan I detect a similar sentiment; the logic goes something like this: ‘We followed your policy recommendations, and look where they got us.’ Ongoing trade skirmishes between the US and Europe -- to say nothing of the recent dispute over the GE-Honeywell merger -- are part of this same script. Fair or not, the legitimacy of such claims is not the issue. Anti-American sentiment is a growing problem around the world. The widening of income disparities between rich and poor nations over the past century adds insult to injury. Globalization is not perceived as the rising tide that lifts all boats. Instead, it is increasingly thought of as the wedge of disenfranchisement. In theory, globalization is all about a shared prosperity -- bringing the less-advantaged developing world into the tent of the far wealthier industrial world. But, in reality, when there’s less prosperity to share, these benefits start to ring hollow. As the world economy now tips into recession, the assault on globalization can only intensify. That’s the tough message from the streets of Genoa.
Mr. Chairman, if this hearing accomplishes one thing, it should underscore America’s commitment to globalization and the principles of free trade on which it rests. Protectionism is antithetical to everything that globalization stands for. However, if a backlash arises, protectionism could be the gravest risk of all. While the voices of dissent are few, they are growing louder. Yet this is not a time to turn back the clock and single out scapegoats for a world in recession. America’s gaping current-account deficit should not be viewed as a lightning rod for pointing fingers at our trading partners. It is a by-product of the profound imbalances that lie at the core of the global economy -- a world that has become overly dependent on a saving-short United States as the engine of global prosperity. Yet it is also a by-product of an American appetite for excess -- and our willingness to rely on foreign capital to sustain that excess. It is time to face these excesses head-on.
There is no guidebook to globalization. We are learning along the way. It is inevitable that we will stumble from time to time. Fortunately, our system is strong enough to give us valuable feedback at critical junctures. This is one of those wake-up calls. The world economy is back in recession for the second time in four years. That, more than anything else, is an unmistakable sign of stresses and strains in the very fabric of globalization. Don’t be tempted by the quick fix as you frame policies aimed at enhancing US and global prosperity. The heavy lifting of reform and structural change is really the only way to make globalization work. We must not squander this opportunity.
Thank you very much. |
